As the Fed is considering whether below-target inflation and soft economic growth data could allow it to make “insurance” rate cuts, emerging markets (EM) currencies should be the main beneficiaries of easier monetary conditions.

EM currencies to benefit from U.S. dollar peak

In our previous quarterly outlook, we envisaged a final leg up in the U.S. dollar (USD) would take the USD index (DXY1) to a level of 98 or higher. The chart below shows the DXY index reached our target level but failed to break above it three times between April and May. We think the greenback is peaking, i.e. that it will not set new highs in the remainder of 2019. The main rationale for our less positive dollar view is the shift in Fed policy. Whereas we previously expected the Fed to raise rates once in 2019, we now think that recent weakness in inflation and growth data will compel the Fed to take out some “insurance” and cut rates by 25 basis points twice.

The European Central Bank (ECB) and the Bank of Japan are also easing policy at the margin, but they have much less room to act on interest rates than the Fed. A declining interest rate gap between the U.S. and the Eurozone/Japan will weigh on the greenback, together with expensive valuation and worsening sentiment. To be sure, we do not forecast the start of a severe bear market for the U.S. dollar, which still enjoys a healthy, albeit diminishing, interest-rate advantage over the euro and the Japanese yen (JPY). In our view, the main beneficiaries of Fed rate cuts are likely to be higher-yielding emerging markets (EM) currencies.

Using the JP Morgan EM Currency Index2 as a yardstick, EM currencies are still trading near their absolute lows over the last decade, as shown in the chart below. Our proprietary valuation models, which are based on several variants of purchasing power parity3, confirm that EM currencies are attractively valued vis-à-vis the U.S. dollar. An environment of easier monetary conditions, mostly driven by the predicted Fed rate cuts and other central banks dialing up their unconventional stimulus, is a benign cycle factor for EM currencies. 

Among developed-market currencies, we still like the Japanese yen best. During the escalation of the trade war between the U.S. and China in May, the yen acted as a safe-haven asset and strengthened considerably against other major currencies. This countercyclical characteristic of JPY makes it particularly valuable as a diversifier in portfolios that have sizeable allocations to equities and other risky assets.

1 The U.S. Dollar Index (DXY) is a measure of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The index goes up when the U.S. dollar gains "strength" (value) when compared to other currencies.

2 The constituents of this index are the Brazilian real, Mexican peso, Chilean peso, Chinese renminbi, Indian rupee, Singapore dollar, Turkish lira, Russian ruble, Hungarian forint, and South African rand.

3 The purchasing power parity exchange rate equalizes the cost of living in two different countries and is used by economists as a measure of the “fair value” of currencies.

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